It is time for our quarterly perspective on the investing environment. As always, we focus on four factors to develop our perspective of investments: stock valuations, the economy, inflation, and interest rates. We will never be so bold as to be the ones to tell you to make wholesale asset allocation changes, but we will discuss the different management styles of the managers we have available and what styles might be most appropriate, given the relative levels of uncertainty that might exist. In other words, our concern here is more about the level of uncertainty in the investing environment, as opposed to a definitive prediction of asset behavior.
Now, without further ado…
Our Three-Point Investment Philosophy
- Proper allocation results from justifying the addition of risk, first.
- Long-term results come from prudence and discretion in the short-term
- The best allocation is governed, in part, by what is best for your plan.
NOTE: All information used in the production of this newsletter is current as of 9/30/21 and can be found by clicking here, unless otherwise noted.
Since the bear market associated with the Great Depression, there have been four macro-economic conditions associated with bear markets:
- Extreme Stock Valuations
- Commodity Spike
- Aggressive Federal Reserve
With that being the case, those are the four characteristics that we evaluate to gain perspective on the investing environment in the short-term.
Extreme Stock Valuations
The S&P 500 finished the third quarter having earned 15.9% year-to-date (YTD), and with a price-to-earnings (P/E) ratio of 20.31x. If the pace of the S&P 500’s growth continues for the balance of the year, it will finish with an attractive return. During the third quarter, however, the pace of its growth decelerated rapidly, as the index only earned 0.6%. At its current valuation, statistical analysis of the last 25 years says that you should expect the P/E ratio of the S&P 500 to be less than it’s current value about 83% of the time, and greater than its current value only 17% of the time. Since 1996, when the S&P 500’s P/E was in the ballpark of today’s value, returns have only been slightly positive over the subsequent 5-year period. As we cover in reviews, however, not all sectors or stocks are created equal, so not all sectors have experienced the appreciation that has driven the S&P 500’s P/E up, as a whole.
The top three performing sectors so far this year have been:
- Energy (43.2%--P/E: 13.5x)
- Financials (29.1%--P/E: 12.4x)
- Real estate (24.4%--P/E: 22x)
The worst three have been:
- Utilities (4.2%--P/E: 18.7x)
- Consumer staples (4.7%--P/E: 19.7x)
- Consumer discretionary (10.3%--P/E: 29.2x).
Further, companies of different sizes and maturities have performed differently, albeit the performance of large cap companies, both mature (Value) and immature (Growth), has been fairly equal:
- Large Cap
- Value: 16.1%--P/E: 15.8x
- Growth: 14.3%--P/E: 28.6x
- Mid Cap
- Value: 18.2%--P/E: 16x
- Growth: 9.6%--P/E: 35.3x
- Small Cap
- Value: 22.9%--P/E: 16.8x
- Growth: 2.8%--P/E: 50.5x
Between that data and the data for the sectors, you might notice a correlation between better performance and lower P/E’s. Generally speaking, you should expect better performance out of stocks—individual, sector, etc.—if they have a lower P/E, but that is obviously not an absolute correlation.
There has been a bit of a sea change, in terms of management styles YTD, and it’s been a little interesting to watch play out. In 2020, the management style tracked by JP Morgan that led to the best performance was Momentum—this is a technical management style that focuses on price movements and the likelihood of the momentum of a price movement to continue. The worst performing style was Value, which is an investment style championed by Warren Buffet that focuses on strong, mature companies. For the past two quarters Value has led the way and Momentum has been at the bottom, but with the closing of the third quarter, Momentum has once again risen to the top and Value has fallen to the bottom. The switch between the two styles is most likely reflective of the simple fact that the markets turned pretty turbulent this last quarter.
Internationally, a similar picture can be found with pockets of opportunity. In developed markets, the UK appears to be the only country whose stocks are cheap relative to their own history and also compared to the rest of the world. Canadian stocks appear to offer some potential, relative to their own history, while Germany appears cheap against the world backdrop. Emerging markets seem to potentially offer more opportunity, but they also offer more risk.
If US stock valuations are to return to more normal territory, then either the P/E numerator must decrease (i.e., stocks must decline in price), the denominator must increase (i.e., company earnings must improve), or a combination of the two must occur. From that vantage point, it seems reasonable to ask the question of which we expect to be most likely to occur. Another way to look at that is to cite an old adage: returns follow earnings. So, which way are earnings likely to go?
In trying to answer that question, we’re going to take a slightly different approach than in the past. The first thing we want to establish is the financial health of corporations—this will tell us how well they are either positioned for growth or to weather any financial turbulence that might be headed our way. Second, since the American consumer is responsible for the health of 69% of our GDP, we will take a close look at the American consumer to get a good idea of how well they are positioned to keep their portion of the GDP in good health.
Gross Domestic Product (GDP) growth was measured at 6.7% for the second quarter of this year, and the economy has, indeed, been growing. Earnings have been experiencing positive momentum and are forecasted to continue, profit margins have rebounded sharply, and corporate tax rates are relatively low. One might be inclined to cite the amount of corporate debt on the books as a reason for concern, but there are several factors that should mitigate any concern: first, interest rates are historically low; second, corporations are sitting on a record amount of cash (Source); and corporate debt service is actually lower than what it was just 5-7 years ago.
So, with corporations looking to be in fairly solid shape, we turn our focus to the consumer. Americans hold $159.3 trillion in interest bearing assets, as compared to only $17.7 trillion in interest bearing liabilities. Further, while government and corporations have been increasing their debt levels, household debt as been decreasing and the household debt service ratio is just about at a 40-year low. In order for the economy to continue to march forward, the consumer needs to remain in good shape, and for workers, that means having a good job and experiencing wage increases.
With the end of the third quarter, we saw yet another reduction in the unemployment figure to 4.9%. So far, 17.4 million of the 22.4 million jobs lost during the pandemic have been recovered. A look at the data from the Bureau of Labor Statistics reveals that just about every measure related to unemployment has been improving. The pace of improvement, however, has slowed significantly, with only 194,000 nonfarm jobs reported as being added in September. In addition, there is an interesting trend of resignations that has been reported on, and it has even been dubbed The Great Resignation (Source).
Upon reading articles, you might find that the significant number of resignations taking place is attributed to workers finding jobs offering better opportunity and compensation. While that might be true, it does seem counterintuitive that such would be the case while we currently have the highest number of job openings in 20 years and hard to fill jobs are reported to be at a 45-year high. Frankly, one has to wonder how much of this is due to COVID vaccines being mandated by employers. Less than 60% of the country is fully vaccinated (Source) and 98.1% of the country’s employers employ 100 people or more, and that roughly translates to ~15% of the country’s population, or 31% of the labor force (Source)—those are the folks who would be subject to the vaccine mandate that President Biden said would be coming from the Occupational Safety and Health Administration.
Again, though it might be true that workers are finding better conditions and compensation, you must also look at the purchasing power of that compensation. The most recent wage growth rate came in at 4.9%, which is almost a full percentage point greater than the 50-year average of wage growth. Inflation, however, was measured at a 5.2% clip, which means that the average worker lost purchasing power. Further, a major source of inflation has come in the energy sector, with its latest measure coming in at 24.9%--it’s hard to imagine a person who wouldn’t be impacted by energy costs.
The reality is that claims that inflation would be transitory seem to have been in err. The pace we lost in the second quarter was regained in the third. Oil is now at a 6-7 year high and the rising tide of inflation appears to be pushing commodity z-scores even higher, which are a measure that tells you how much costs deviate from their norm. Compounding the inflation picture is a major supply chain issue and delivery times are significantly greater than the norm for the last 15 years or so. Add to that the fact that the M2 money supply is at its highest point ever (Source), and this sets the table for inflation to continue, but it will most likely accelerate (Source).
Aggressive Federal Reserve
If you look at a chart of inflation and interest rates, you will see that changes in inflation and interest rates seem to coincide. This would make sense, given that one of the charges of the Federal Reserve is to manage inflation. Now, the Fed has said that it will remain accommodative and even let inflation run hot, given how low it has been for so long, but one has to wonder how long the Fed will be comfortable with just sitting back with inflation being what it is currently, not to mention if the pace picks up. Moreover, given the experience we had with the jump in interest rates in the first quarter, especially as measured by the 10-year Treasury, it would be reasonable if one was to also wonder whether the Fed will be compelled to act by outside circumstances.
We would be remiss if we didn’t mention the political climate and nonpharmaceutical interventions aimed at mitigating COVID. The division in the branches of government are traditionally heralded as good for business, because it is hard to get major legislation passed in a divided government. In today’s climate, however, a lack of uncertainty due to new legislation being passed seems to have been replaced by a lack of certainty attributable to executive policy-making—this would be true at all levels. The reality is that the unpredictability of government policy is only compounded by the unpredictability of the virus, itself, and that makes it extremely difficult to get a directional read on the winds of change. That, however, is kind of the point—that is uncertainty. So, in closing this newsletter, we will simply revisit the concept of uncertainty and say there seems to be quite a lot.